I just read your book "a Rookie's Guide to Options" and I loved it. I would say it is a must read for anyone who is getting into options. I have already recommended your
strategies to some of my friends.
I am currently trying out a covered call strategy using ETF's. My typical game plan was to sell one month calls but I noticed that May OTM call prices were quite low (compared
to what I got in April) so I decided to sell June OTM calls (not sure if this was necessarily a smart move). I did this without considering volatility.
After reading your book and the chapter on volatility I went back and calculated the implied volatilities on the calls I sold (based on the price I got) and compared to historical volatilities on these same ETF's. What I discovered that across the board the implied volatilities were significantly lower than historical. Now I am second guessing myself and wondering whether "accepting" the low implied volatilities (and low option prices) was the right thing to do.
This leads me to my questions. What would you recommend for covered call sellers in the situation where the implied volatility is much lower than historical? Is it better to
sell no options and wait for the next month? In the long run is it a losing proposition to sell options at an implied volatility significantly less than historical? Or would you "take what you can get" and accept what the market is paying?
Also, what time period would you recommend to look at when determining historical volatlity? The website you recommended in your book provided 20, 50 and 100 day historical volatilities.
Thanks in advance for your answers, and once again congratulations on writing a great book.
Are you you are new at this? You are asking very intelligent questions that show some sophistication regarding the writing of covered calls.
1) Thanks for the kind words about the book. I wanted a book that provided more than enough information for newbies to avoid mistakes that cost money. I hope it becomes the new bible for option rookies.
2) Regarding the 'right' thing to do. There is almost never a universal answer because each investor has different needs.
3) My preference is to take what I can get. That's because I don't want to own any stock that is unhedged and I want to collect some premium. And I write calls every month when I own stocks. But, that's my bias. Other may feel that option premium is too low, so they intend to hold without writing covered calls, hoping the market moves higher. Others play the market. By that I mean they choose not to write for a period of time because they are bullish. That's not for me, but if you have a proven track record of being able to time the market, you can refuse to sell options any time. But, as I said, that's not for me.
On the other hand, over the long-term, it's a losing proposition to sell options for less than they are worth. But, the problem is knowing what they are worth and what the volatility is going to be in the coming month, not what has it been historically. That's the problem with volatility estimates. We must use something to estimate the option's value, and to me, historical volatility represents the best guess. Most of the time when implied volatilities are low (and if you think they are low now, 'you ain't seen nothin' yet' - VIX was trading at about half of its current level not so long ago), the markets are less volatile and it's okay to accept a reduced premium for the option. I know this is not an answer you can use - because there's a lot of art involved with option trading. It's not as simple as it would be if it were more scientific. If the option premium feels too low, then you can wait. There's no way to know, in advance, whether it's best to write a
covered call. Obviously at some point, an option's premium is too small to sell. I wouldn't sell a 15 cent call option on a $25 index. I'd rather pass.
4) Regarding selling June options. That's a good idea. Sometimes selling options that expire in two months provides a better annualized return than selling one-month options - especially after taking trading costs into consideration. The trap to avoid - and you did avoid it - is not to sell longer-term options when implied volatilities are low. If you ever write longer-term options, it should only be when implied volatilities are high. That way you can lock in a good rate of return for a longer period of time.
5) Keep in mind that ETFs generally have lower option prices than similarly priced individual stocks. That's because they are safer to own and are less volatile. When periods of decreased option prices occur, that makes the returns small. But, more safety must correspond with lower option prices, so it's not such a bad thing.
6) Historical volatility. If the stock has been unusually volatile lately (20-day is higher than 100-day), then I would use the 20-day HV as being more indicative of current trends. Of course, if you know why the stock has been more volatile (news was just released) and that the trend should be over, then I'd revert to the 100-day. If the 20, 50, and 100- day are all considerably different, then there's a problem without an easy solution. I'd use 20-day because 'something has changed' in the trading properties of the stock, and unless you know what that something is, there's no way to know if or when it will end.
Mark D. Wolfinger
The Rookie's Guide to Options:
The Beginner's Handbook of Trading Equity Options